Chapter 11
Long-Term Liabilities: Notes, Bonds, and Leases
Multiple Choice Questions
1. Which one of the following will result from receiving cash upon issuing long-term debt?
a. Increase of the company's indebtedness
b. Decrease of the current ratio
c. Increase of retained earnings
d. Increase of total shareholders’ equity
Answer: A
2. If the maximum debt/equity ratio as specified by a debt covenant is close to being violated,
which one of the following actions would increase the likelihood of violating the debt
covenant?
a. Issuing capital stock
b. Skip current cash dividends
c. Acquire money by issuing a non-interest-bearing note payable
d. Acquire money by collecting accounts receivable
Answer: C
3. If the maximum debt/equity ratio as specified by a debt covenant is close to being violated,
which of the following actions would help avoid a violation of the covenant?
a. Purchase long-term investments
b. Increase current cash dividends declared
c. Exchange bonds payable for common stock
d. Acquire money by selling land at its balance sheet value
Answer: C
4. The debt/equity ratio will increase if a company
a. pays off its long-term debt.
b. decides to pay cash for more of its capital purchases.
c. purchases long-term investments for cash.
d. declares more current cash dividends.
Answer: D
5. A non-interest-bearing obligation
a. requires recognition of interest expense over the life of the obligation.
b. is an example of an installment obligation.
c. requires collateral.
d. is free of interest expense.
Answer: A
6. The difference in computing the effective interest rate for non-interest-bearing obligations
as compared to installment obligations is
a. one has an interest rate of zero, while the other is determined using present value factors.
b. one uses the ‘present value of a single sum’ table and the other uses the ‘present value of
an ordinary annuity’ table.
c. one is based on the market rate of interest, while the other is based on a stated rate of
interest.
d. determined by the length of the debt maturity period.
Answer: B
7. Interest expense recognized over the life of an obligation is the difference between cash
received at the time of issuance and cash paid over the life of the obligation for
a. dividends declared.
b. convertible bonds.
c. non-interest-bearing obligations.
d. receivables due from customers.
Answer: C
8. Payments on an installment obligation typically include the payment of
a. principal only.
b. both principal and interest.
c. interest only.
d. interest, but only if collateral is involved.
Answer: B
9. Which one of the following is needed in order to find the present value of an obligation?
a. The discount rate of the associated cash flows
b. All debt covenants that are a component of the obligation
c. The gross profit rate of the borrower
d. The rate of inflation during the year
Answer: A
10. How is interest expense calculated according to GAAP?
a. Stated rate of interest x maturity value.
b. Effective interest rate x maturity value of the obligation.
c. Effective interest rate x balance sheet value.
d. Stated rate of interest x balance sheet value.
Answer: C
11. Interest expense calculated under GAAP is equal to the stated rate of interest times the
maturity value if the interest-bearing obligation is issued at
a. a discount.
b. either a discount or a premium.
c. a premium.
d. par.
Answer: D
12. If a company issues a non-interest-bearing note payable, then
a. no interest expense will be recognized over the life of the note.
b. no principal payments will be made over the life of the note.
c. no interest payments will be made over the life of the note.
d. the covenants should be rewritten to conform to GAAP.
Answer: C
13. If a company issues a non-interest-bearing note payable, then
a. the cash received will exceed the maturity value of the note.
b. the interest is not accrued.
c. the cash received will be less than the maturity value of the note.
d. the cash received will be more than the maturity value of the note.
Answer: C
14. If a company issues a note payable when the market rate of interest is greater than the
stated rate, then
a. the cash received will exceed the maturity value of the note.
b. the note will be issued at a discount.
c. the note will be issued at a premium.
d. the cash received will be equal to the maturity value of the note.
Answer: B
15. If a company issues a note payable when the market rate of interest is less than the stated
rate, then
a. the note will be discounted at maturity.
b. the cash received will be equal to the maturity value of the note.
c. the cash received will exceed the maturity value of the note.
d. the note will be issued at a discount.
Answer: C
16. If a company issues a note payable when the market rate of interest is equal to the stated
rate, then
a. the cash received will exceed the maturity value of the note.
b. the note will be issued at a discount.
c. the note will be issued at a premium.
d. the note will be issued at par.
Answer: D
17. If an interest-bearing note payable is issued at par, then the contractual cash payment for
interest is
a. equal to interest expense.
b. less than interest expense.
c. greater than interest expense.
d. It cannot be determined from the information given.
Answer: A
18. If an interest-bearing note payable is issued at a discount, then the contractual cash
payment for interest is
a. less than interest expense.
b. greater than interest expense.
c. equal to interest expense.
d. ignored since no interest payment will be made.
Answer: A
19. If an interest-bearing note payable is issued at a premium, then the contractual cash
payment for interest is
a. greater than interest expense.
b. less than interest expense.
c. equal to interest expense.
d. based on the market rate of interest.
Answer: A
20. If interest expense is greater than the contractual interest payment, then
a. the note was issued at par.
b. a debt covenant violation occurred.
c. the note was issued at a premium.
d. the note was issued at a discount.
Answer: D
21. If interest expense is less than the contractual interest payment, then
a. the note was issued at a premium.
b. the note was issued at a discount.
c. the note was issued at par.
d. the company should refinance the note to get a better interest rate.
Answer: A
22. If interest expense is equal to the contractual interest payment, then
a. the note was issued at a premium.
b. the note was issued at a discount.
c. the note was issued at par.
d. It cannot be determined from the information given.
Answer: C
23. A debt covenant
a. serves to give assurance to a creditor that the debtor will have the ability to pay interest and
principal at maturity.
b. serves to give assurance to the debtor that the interest rate is reasonable.
c. allows the creditor to become an owner of the company if the covenant is violated.
d. allows the debtor to forego any interest on the debt.
Answer: A
24. On January 1, a 6-year, $5,000, non-interest-bearing note payable was issued when the
market rate of interest was 8%. The present value of the note is
a. $3,151.
b. $2,080.
c. $865.
d. $5,000.
Answer: A
$5,000 x .6302 = $3,151
25. On January 1, a 3-year, $8,000, non-interest-bearing note payable was issued when the
market rate of interest was 11%. To determine the amount at which the note will be valued on
the balance sheet on the issue date, use the
a. present value of $1 table.
b. future value of an annuity due table.
c. present value of an annuity table.
d. future value of an annuity table.
Answer: A
26. On January 1, a 7-year, $8,000, non-interest-bearing note payable was issued when the
market rate of interest was 7%. What amount should be recorded for the note on the balance
sheet at the issue date?
a. $3,570
b. $4,982
c. $11,241
d. $37,725
Answer: B
$8,000 x .6227 = $4,982
27. Companies generate assets in three different ways. They are
a. equity contributed by owners, borrowings, and receivables from affiliates.
b. equity issuances, borrowings, and interest rates.
c. borrowings, profitable operations, and equity issuances.
d. equity issuances, debt issuances, and financial instruments.
Answer: C
28. Which one of the following is not one of the possible kinds of notes?
a. Non-interest-bearing note
b. Interest-bearing notes
c. Installment notes
d. Bank notes
Answer: D
29. Which type of note consists of periodic payments covering both interest and principal?
a. Interest-bearing bond
b. Receivable note
c. Non-interest-bearing note
d. Installment note
Answer: D
30. A provision of a contractual obligation that is designed to protect the interest of lenders is
called
a. a lenders’ security provision
b. a restrictive covenant.
c. a non-interest-bearing obligation.
d. collateral.
Answer: B
31. The actual interest rate used to calculate the interest payments by the issuer of the
obligation is
a. the market rate of interest.
b. the effective interest rate.
c. the stated interest rate.
d. equal to the actual interest expense rate.
Answer: C
32. A non-interest-bearing note was recorded in the accounting records. The book value of the
note
a. remains the same during the maturity period.
b. decreases during the maturity period.
c. increases throughout the maturity period.
d. is reported on income statement.
Answer: C
33. A five-year, non-interest-bearing, $5,000 note, dated January 1, 2010, has a present value
of $3,917. The market rate of interest is 5%. Interest expense for the period ending December
31, 2010, is
a. $392.
b. $196.
c. $250.
d. $217.
Answer: B
$3,917 x 5% = $196
34. A coupon payment is
a. the payment of principal that is the ‘coupon’ of the total payments.
b. the amount of interest expense reported on the income statement.
c. calculated by multiplying the book value of the bonds times the effective rate of interest.
d. the amount paid to bondholders on each interest payment date.
Answer: D
35. A call provision in a bond contract may specify that the issuing company
a. can issue the bonds at any interest rate it can entice the investors to accept.
b. must make periodic interest payments.
c. must deposit cash in the bank to be available when the bonds mature.
d. may buy back bonds from the investors.
Answer: D
36. Which one of the following bonds is considered unsecured?
a. $50,000, 8%, debenture bonds
b. $100,000, 12%, restricted bonds
c. $20,000, 10%, five-year callable bonds
d. $40,000, 6%, collateralized bonds
Answer: A
37. RJC Company issued $8,000 of 10% bonds on January 1, 2009. The bonds were issued at
a premium. The cash payment for annual interest on the bonds
a. is equal to annual interest expense.
b. is greater than annual interest expense.
c. is less than annual interest expense.
d. equals the balance in Premium on Bonds Payable on the day the bonds were issued.
Answer: B
38. Darren Company issued $8,000 of 8% bonds on January 1, 2010, at a discount of $940.
The market rate of interest on the issue date was 10%. The carrying value of the bonds on
December 31, 2010 is
a. $6,994.
b. $7,060.
c. $8,940.
d. $7,126.
Answer: D
$7,060 + [($7,060 x .10) - ($8,000 x .08)] = $7,126
39. The amount of amortized bond premium
a. reduces interest expense on the income statement.
b. is reported as a deduction from bonds payable on the balance sheet.
c. is reported as an addition to bonds payable on the balance sheet.
d. is added to the present value of bonds.
Answer: A
40. Bonds payable that are redeemed by the issuer
a. typically pay far less interest than the market rate of interest.
b. are considered unsecured.
c. have no market value.
d. are repurchased or retired .
Answer: D
41. Financial instruments that are not listed on the balance sheet of a company
a. may involve significant risks that must be disclosed in the notes to the financial statements.
b. are reported as assets if the company can determine the fair value.
c. must be reported as a liability on the balance sheet at the end of the accounting period.
d. must be reported on the income statement.
Answer: A
42. Which one of the following is not a financial instrument?
a. Dividends paid
b. Short-term investment in equity securities
c. Bonds payable
d. Notes receivable
Answer: A
43. Capital leases are rental agreements of which
a. periodic rental payments are recorded as rental revenue on the asset owner’s income
statement.
b. the contractual arrangements are similar to a purchase in all respects.
c. the period of the lease is generally a very small portion of the leased asset's useful life.
d. the lessee desires to have rights to use the asset but not ownership of such asset.
Answer: D
44. Woodsman Company issued $400,000 of 6-year, 6% bonds with interest payments
occurring annually at the end of each year. What additional information is needed in order to
determine the selling price of these bonds?
a. The face amount of the bonds
b. The bond covenants
c. The market rate of interest
d. The stated rate of interest
Answer: C
45. Gibson Corporation amortizes its bonds using the effective interest method. Which
statement is correct?
a. [Interest expense] = [Stated rate] X [Carrying value of the bonds]
b. [Interest expense] – [Cash interest paid] = [Increase in carrying value if sold at a discount]
c. [Cash interest payment] = [Bond face amount] X [Market interest rate]
d. [Interest expense] – [Cash interest paid] = [Increase in carrying value if sold at a premium]
Answer: B
46. GAAP requires the lessee party to a capital lease
a. to record the lease on its balance sheet at the present value of future lease payments.
b. to record rental revenue as each lease payment is received.
c. to depreciate the leased asset.
d. to transfer ownership to the lessee.
Answer: A
47. Operating leases are treated as
a. increases in liabilities for both the lessor and the lessee.
b. a sale if the leased asset has been transferred from the lessor to the lessee.
c. capital leases by the lessee.
d. rental expense by the lessee.
Answer: D
48. Which one of the following is one of the capital lease criteria?
a. The lease term is 75% or more of the useful life of the leased property.
b. Ownership of the property is transferred back to lessor at the end of the lease term.
c. The present value of the lease payments equals or exceeds 75% of the FMV of the
property.
d. The lease does not contain a bargain purchase option.
Answer: A
49. Countries throughout the world typically
a. pay extremely large dividends to shareholders.
b. rely heavily on local stock and bond markets.
c. have less comprehensive accounting disclosure requirements than the U.S.
d. carry a normal debt/equity ratio that is less than 25%.
Answer: C
50. Investments in bonds are accounted for using
a. historical cost.
b. capital leases.
c. the effective interest method.
d. net realizable value.
Answer: C
51. Perfectly effective hedges using interest rate swaps will always
a. exactly match maturity dates with the underlying debt.
b. minimize interest expense.
c. maximize gains in bond values caused by interest rate fluctuations.
d. all of the above.
Answer: A
52. McCourt Investment Advisors purchased newly issued bonds on October 1, 2005, paying
$108,983. The bonds had a face value of $100,000, maturing on September 30, 2010, and pay
interest semiannually on March 31 and September 30. The stated interest rate is 6%. What is
the effective interest rate?
a. 4%.
b. 5%.
c. 6%.
d. 7%.
Answer: A
Because the bonds were issued at a premium, we know that the effective interest rate is lower
than the stated rate. This eliminates answers c. and d. Our tables do not allow us to compute
the present value of the interest at 5% because our table doesn’t include a 2.5% column. This
leaves 4% as a possible solution. The following computation of the present value of the future
cash flows at 4% arrives at our purchase price, proving that 4% is the effective rate.
Answer: A
53. The following information was extracted from the financial records of Lewis Company.
Based on this information, what is the effective interest rate on the notes payable?
a. 8.2%
b. 8.8%
c. 6.0%
d. 2.2%
Answer: B
54. The following information was extracted from the financial records of Lewis Company.
Based on this information, the journal entry Lewis Company should prepare to record interest
expense during 2010 would include:
a. a credit to Interest Payable for $32,800.
b. a credit to Discount on Notes Payable for $24,000.
c. a credit to Cash for $28,000.
d. a credit to Notes Payable for $4,800.
Answer: C
55. On September 10, 2009, Humbert Company issued bonds with a face value of $600,000
for a price of 96. During 2012, Humbert exercised a call provision and redeemed the bonds
for 101. At the time of the redemption, the bonds had a balance sheet value of $590,000. The
journal entry to record the redemption includes:
a. a credit to Bonds Payable for $576,000.
b. a debit to Loss on Redemption for $16,000.
c. a credit to Discount on Bonds for $24,000.
d. a debit to Discount on Bonds Payable for $10,000.
Answer: B
56. On September 10, 2009, Humbert Company issued bonds with a face value of $600,000
for a price of 102. During 2012, Humbert exercised a call provision and redeemed the bonds
for 101. At the time of the redemption, the bonds had a balance sheet value of $607,000. The
journal entry to record the redemption includes:
a. a credit to Gain on Redemption for $1,000.
b. a debit to Premium on Bonds for $7,000.
c. a credit to Discount on Bonds for $7,000.
d. a credit to Bonds Payable for $600,000.
Answer: B
57. Brown Company is about to issue $300,000 of 8-year bonds paying a 12% interest rate
with interest payable semiannually. The effective interest rate for such securities is 10%.
Below are available time value of money factors that Brown chooses from to calculate
compounded interest.
To the closest dollar, how much can Brown expect to receive for the sale of these bonds?
a. $319,339
b. $229,371
c. $332,513
d. $540,000
Answer: C
58. Stevens Company is about to issue $400,000 of 10-year bonds paying an 8% interest rate
with interest payable semiannually. The effective interest rate for such securities is 10%.
Below are available time value of money factors that Stevens chooses from to calculate
compounded interest.
To the closest dollar, how much can Stevens expect to receive for the sale of these bonds?
a. $350,151
b. $292,637
c. $800,000
d. $1,405,503
Answer: A
59. Torrey Corporation issued $1,000,000 of ten-year, 10 percent bonds payable dated
January 1, 2009. The market rate of interest at that time was 11 percent. The journal entry to
record this transaction will include a:
a. debit to Bond Discount.
b. credit to Bond Premium.
c. credit to Bond Discount.
d. credit to Cash.
Answer: A
60. Crosson Company uses the straight-line method of amortization and had a ten-year, 12
percent, $1,000,000 bond issue outstanding that had been sold at a $12,000 discount in 2008.
The bonds pay interest on June 30 and December 31, and the company’s fiscal year end is
December 31. The journal entry on June 30, 2011, will include:
a. a $6,000 credit to Cash.
b. a $1,200 credit to Bond Premium.
c. a $58,800 debit to Interest Expense
d. a $600 credit to Bond Discount.
Answer: D
61. Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2006, when the
market interest rate was 10 percent and received $107,732 for them. The bonds mature on
January 1, 2011 and pay interest on June 30 and December 31. Duncan uses the effective
interest method of amortization. The annual cash payment for interest on the bonds are:
a. $10,000
b. $12,000
c. $5,000
d. $6,000
Answer: B
62. Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2006, when the
market interest rate was 10 percent and received $107,732 for them. The bonds mature on
January 1, 2011 and pay interest on June 30 and December 31. Duncan uses the effective
interest method of amortization. The June 30, 2006 entry will include:
a. A $5,000 debit to Interest Expense.
b. A $5,386.60 debit to Interest Expense
c. A $5,000 credit to Cash
d. A $5,386.60 debit to Bond Premium
Answer: B
63. Duncan Industries sold $100,000 of 12 percent bonds on January 1, 2006, when the
market interest rate was 10 percent and received $107,732 for them. The bonds mature on
January 1, 2011 and pay interest on June 30 and December 31. Duncan uses the effective
interest method of amortization. The interest expense for 2006 is:
a. $12,000.00
b. $10,000.00
c. $107,734
d. $9,246
Answer: C
64. Bowlin Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1,
2008, when the market rate of interest was 10 percent. The bonds mature in ten years and pay
interest on June 30 and December 31. Bowlin’s fiscal year ends on December 31and the
company uses the effective interest method of amortization. The interest expense for the six
months ending December 31, 2008 is:
a. $50,000.00
b. $45,000.00
c. $46,889.50
d. $93,779.00
Answer: C
65. Bowlin Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1,
2008, when the market rate of interest was 10 percent. The bonds mature in ten years and pay
interest on June 30 and December 31. Bowlin’s fiscal year ends on December 31and the
company uses the effective interest method of amortization. The book value of the bonds on
December 31, 2008 is:
a. $1,000,000.00
b. $944,011.00
c. $941,452.90
d. $939,679.50
Answer: D
66. Burns Company issued $1,000,000 of 9 percent, ten-year bonds for $937,790 on July 1,
2010, when the market rate of interest was 10 percent. The bonds mature in ten years and pay
interest on June 30 and December 31. Burn’s fiscal year ends on December 31 and the
company uses the effective interest method of amortization. The journal entry on December
31, 2010 will include:
a. a debit to Interest Expense for $45,000.00
b. a credit to Bond Discount for $1,889.50
c. a credit to Interest Payable for $45,000.00
d. a credit to Cash for $46,973.95
Answer: B
67. Barkley Brothers Inc. shows the following information on its balance sheet for December
31, 2010.
The bonds have a stated annual interest rate of 5 percent and will mature on December 31,
2012. The market value of the bonds as of December 31, 2010, is $98,167. Assume that
Barkley retired the bonds by purchasing them on the open market. The journal entry to record
this purchase would include:
a. a credit to Bonds Payable for $100,000.
b. a debit to Discount on Bonds Payable for $5,350.
c. a credit to Discount on Bonds Payable for $5,350.
d. a debit to Cash for $98,167.
Answer: C
Matching Questions
1. Identify the balance sheet classification (a through e) in which each account description
numbered 1 through 7 would be reported. You may use each letter more than once or not at
all. You may assign more than one category to an account if it can be classified in more than
one category.
Balance Sheet Classifications
a. Current assets
b. Long-term assets
c. Current liabilities
d. Long-term liabilities
e. Not reported on the balance sheet
____1. Loss on redemption
____2. 1-year non-interest-bearing note receivable
____3. Discount on bonds that mature in 3 years
____4. 6-month note payable
____5. Premium on bonds issued that mature in 8 months
____6. Discount on notes payable due in 12 months
____7. Lease liability on a 5-year capital lease paid annually
Answer:
1. e
2. a
3. d
4. c
5. c
6. c
7. c and d
2. Identify the effect(s) as a result of each transaction listed as 1 through 4 below by placing
the letter of the effect on total liabilities and the effect on net income in the two columns
provided. Keep in mind that there are currently no accrued expenses recorded on the balance
sheet as liabilities.
Solution:
1. I, X
2. D, D
3. I, D
4. X, D
3. Identify which accounting effect (a through e) occurs as a result of each transaction
numbered 1 through 6. You may use each letter more than once or not at all.
____ 1. Issued a bond payable at a premium
____ 2. Issued a bond payable at a discount
____ 3. Issued a non-interest-bearing note at a discount
____ 4. Paid periodic interest and amortized discount to interest expense
____ 5. Paid periodic interest and amortized premium to interest expense
____ 6. Paid interest on bond payable which was issued at par
Answer:
1. a
2. a
3. a
4. e
5. c
6. d
4. Identify the effect(s) on the debt/equity ratio (a through c) as a result of each transaction
numbered 1 through 6 below. You may use each letter more than once or not at all.
____ 1. Acquired the use of equipment under a capital lease
____ 2. Paid the interest portion of the payment on a capital lease
____ 3. Paid the principal portion of the payment on a capital lease
____ 4. Acquired the use of equipment under an operating lease
____ 5. Payment required on an operating lease
Answer:
1. a
2. a
3. b
4. c
5. a
5. Identify which accounting effect (a through e) occurs as a result of each transaction
numbered 1 through 6. You may use each letter more than once or not at all.
____ 1. Acquired the use of equipment under a capital lease
____ 2. Paid the interest portion of the payment on a capital lease
____ 3. Paid the principal portion of the payment on a capital lease
____ 4. Depreciation of equipment leased under a capital lease
____ 5. Acquired the use of equipment under an operating lease
____ 6. Payment required on an operating lease
Answer:
1. a
2. d
3. c
4. d
5. e
6. d
6. Identify the effect(s) on the debt/equity ratio (a through c) as a result of each transaction
numbered 1 through 6 below. You may use each letter more than once or not at all.
____ 1. Issued a bond payable at a discount
____ 2. Issued a non-interest-bearing note at a discount
____ 3. Issued an interest-bearing note at a premium
____ 4. Amortized discount to interest expense
____ 5. Paid interest on bonds payable that was issued at par
____ 6. Market value of bonds payable increased after issue date
____ 7. Retired a bond issue by paying cash
Answer:
1. a
2. a
3. a
4. a
5. a
6. c
7. b
Short Problems
1. On January 1, 2010, Lukens Corporation issued 5-year bonds with a $50,000 face amount
and a 6% annual coupon rate paid annually on January 1. The bonds were issued at $44,166
when the market rate of interest was 9%.
A. Prepare the journal entry to record the issuance of the bonds on January 1, 2010. Round to
the nearest dollar.
B. Were the bonds issued at a premium or discount? How do you know?
Answer:
B. The bonds were issued at a discount. Two items reflect this—the issue price is less than the
face amount of the bonds, and the market rate of interest is greater than the stated rate of
interest.
2. On January 1, a 3-year, $1,090 non-interest-bearing note payable was issued for $942
when the market rate of interest was 5%. How much interest expense will Hamlen recognize
in each of the first two years using the effective interest method? Round to the nearest dollar.
Answer: First year interest expense: $942 x .05 = $47
Second year interest expense: ($942 + $47) x .05 = $49
3. On January 1, 2010, Hooper Corporation issued 3-year bonds with a $40,000 face amount
and a 6% annual coupon rate paid annually on December 31. The bonds were issued at
$36,021 when the market rate of interest was 10%. Complete the amortization table for the
bonds using the effective interest method. Round all amounts to the nearest dollar.
Answer:
4. On January 1, a 5-year, $5,000 non-interest-bearing note payable was issued when the
market rate of interest was 9%. What are the proceeds from this issue? Round your final
answer to the nearest dollar.
Answer: $5,000 x .6499 = $3,249
5. On January 1, a 5-year, $4,000 non-interest-bearing note payable was issued for $2,600
when the market rate of interest was 9%. What is the total interest expense that will be
recognized over the life of the note? Round your final answer to the nearest dollar.
Answer: Cash paid ($4,000) – Cash received ($2,600) = $1,400
6. On January 1, a 3-year, $10,000 non-interest-bearing note payable was issued for $7,938
when the market rate of interest was 8%. Interest expense is recognized using the effective
interest method. Calculate the balance sheet value of the note a year after its issuance. Round
your final answer to the nearest dollar.
Answer: $7,938 + $635 = $8,573
7. Samuels Corporation issued a $40,000, 3-year, non-interest-bearing note payable on
January 1, 2009. Reflecting a market rate of interest of 10%, Garrison received $30,053.
Calculate interest expense (to the nearest dollar) for 2009 and 2010.
Answer: 2009: $30,053 x .10 = $3,005
2010: ($30,053 + $3,005) x .10 = $3,306
8. On January 1, 2009, Pacific Corporation issued a 3-year, 8%, $5,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 10%. The bond was issued at $4,750. Calculate the total
interest expense over the 3-year life of the bond independent of the particular accounting
method used to recognize interest expense each year.
Answer: [$5,000 – $4,750] + (3 x (8% x $5,000)] = $1,450
9. On January 1, 2009, Mango Corporation issued a 3-year, 4%, $3,000 bond payable.
Beginning in 2010, interest is payable every year on January 1 over the life of the bond. The
market rate of interest on January 1, 2009 is 6%. What are the proceeds received by Mercer
from the issue of this bond on January 1, 2009?
Answer:
10. On January 1, 2009, Sheena Corporation issued a 3-year, 7%, $4,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The bonds
were issued at 104¼. Calculate the issue price.
Answer: 104¼ x $4,000 /100 = $4,170
11. On January 1, 2009, Enron Corporation issued a 4-year, 7%, $9,000 bond payable.
Beginning in 2010, interest is payable annually every January 1. The market rate of interest at
issuance is 9%. How much are the interest payments by Enron? Why is the amount of interest
expense different than the cash payments?
Answer: 7% x $9,000 = $630 per year for 4 years
Interest expense is different since it is based on the market rate of interest of 9%. The investor
will earn and the issuer must incur the market rate for both parties to be in agreement on the
bond transactions, i.e., the investor demands to earn 9% on this bond since he can earn 9% on
other investments in the market. Conversely, the issuer will not attract any investors unless it
provides a return of 9% to the investors.
12. On January 1, 2009, Precision Corporation issued a 3-year, 7%, $2,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 10%. If Precision uses the effective interest method,
what is the balance sheet value of the bond payable on January 1, 2009?
Answer: PV of principal of $2,000 for n=3, I=10: $2,000 x .7513 = $1,503
PV of interest of $140 for n = 3, I = 10: $140 x 2.487 = $348
Total: $1,503 + $348 = $1,851
13. On January 1, 2009, Edison Corporation issued a 4-year, 8%, $5,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 10%.
A. Calculate the contracted cash interest payments by Edison as specified by this bond.
B. Will the total interest expense over the life of the bond be less than or greater than the total
cash payments for interest? Explain.
Answer: A. .08 x $5,000 = $400 per year for 4 years
B. Interest expense will be greater than the total of the cash interest payments because the
cost to the bond issuer is based on the market rate, which is greater than the stated rate of
interest.
14. On January 1, 2009, Lundell Corporation issued a 5-year, 4%, $2,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The bonds
were issued at 105 3/4. How much cash did Lundell receive from issuing the bonds on
January 1, 2009?
Answer: 105 3/4 x $2,000 /100 = $2,115
15. On January 1, 2009 Frank Corporation issued a 3-year, 9%, $5,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 6% when the bonds were issued at 108. Calculate the
total interest expense over the 3-year life of the bond independent of the particular accounting
method used to recognize interest expense each year.
Answer: Total cash paid: $5,000 + (9% x $5,000 x 3) = $6,350
Cash received: 108 x $5,000 /100 = $5,400
Interest expense: $6,350 – $5,400 = $950
16. On January 1, 2009, Field Corporation issued a 3-year, 9%, $5,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 6%. What is the impact of the debt/equity ratio as a
result of the issuance?
Answer: The issuance causes an increase in assets (cash) and liabilities (bonds payable). The
debt/equity ratio increases.
17. On December 31, 2009, Creative Corporation issued a 3-year, 9%, $1,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on December 31, 2009 is 5%. If Creative uses the effective interest method,
show how the bonds will appear on Creative’s balance sheet at December 31, 2009.
Answer:
Interest: 9% x $1,000 x 2.723 = $245
Principal: $1,000 x .864 = $864
Principal and interest = $245 + $864 = $1,109
18. On January 1, 2009, Luna Corporation issued a 5-year, 7%, $5,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 7%. Luna uses the effective interest method. Calculate
the balance sheet value of the bond payable on January 1, 2010.
Answer: $5,000 (issued at par)
19. On January 1, 2009, Richardson Company leased equipment under a 3-year lease with
payments of $8,000 on January 1, 2010, 2011, and 2012. The present value of the lease
payments at a discount rate of 7% is $20,992. RIchardson uses straight-line depreciation with
no salvage value. The lease is considered a capital lease. Calculate depreciation expense and
interest expense for 2009.
Answer: Depreciation expense: $20,992 / 3 = $6,997
Interest expense: $20,992 x 7% = $1,470
20. On January 1, 2010, Foster Corporation issued a 2-year, non-interest-bearing, $4,000 note
payable. Interest is payable each December 31 during the life of the note. When the note was
issued, the market rate of interest was 6%. Complete the following amortization schedule:
Answer:
21. On January 1, 2009, Parker Company leased equipment under a 3-year lease with
payments of $5,000 on each December 31 of the lease term. The present value of the lease
payments at a discount rate of 12% is $12,010. If the lease is considered a capital lease,
depreciation expense (straight-line) and interest expense are recognized. If the lease is
considered an operating lease, then rent expense is recognized. What is the difference in the
total combined net incomes of 2009, 2010, and 2011, if the lease is considered a capital lease
instead of an operating lease?
Answer: The total expense for the next three years under the 3-year lease will be the total
cash paid of $15,000. If the lease is an operating lease, then the $15,000 is recognized as rent
expense. If the lease is a capital lease, then the $12,010 is recognized as depreciation
expense. Interest expense would then be the difference between the present value of $12,010
and the principal of $15,000, for a total of $2,990. The total expense for either type of lease
will be $15,000 so there is no difference in the total net incomes.
22. On January 1, 2009, Action Corporation issued a two-year, 5%, $1,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on January 1, 2009 is 3%. Calculate the present value of the bond issued by
Action on January 1, 2009.
Answer: $50 x 1.913 = $96
$1,000 x .943 = $943
Principal and interest = $96 + $943 = $1,039
23. On January 1, 2009, Alcon Corporation issued a 5-year, 10%, $10,000 bond payable.
Beginning in 2010, interest is payable every January 1 over the life of the bond. The market
rate of interest on the issue date is 10%. Calculate the interest expense for 2009 using the
effective interest method.
Answer: First year interest expense: $10,000 x 10% = $1,000 (issued at par)
24. On January 1, 2009, Mega Company leased equipment under a 5-year lease with
payments of $7,000 on each December 31 of the lease term. The present value of the lease
payments at a discount rate of 9% is $27,230. The lease is considered a capital lease.
A. Determine the amount of the leased asset and lease obligation on January 1, 2009.
B. Why are some leases accounted for as purchases by the lessee?
Answer:
B. The lessee treats a lease as a purchase when the rights, risks, and benefits of ownership
have in substance, been acquired.
25. On January 1, 2009, Seaside Company leased equipment under a 5-year lease with
payments of $3,000 on each December 31 of the lease term. The present value of the lease
payments at a discount rate of 7% is $12,300. The lease is considered a capital lease.
Calculate depreciation expense (straight-line with no salvage) and interest expense for 2009.
Answer: Depreciation expense: $12,300/5 = $2,460
Interest expense: $12,300 x 7% = $861
26. On January 1, 2010, Jackson Corporation issued a 4-year, 12%, $20,000 installment note
payable. The payment on this note is $6,585 and is paid annually at year-end beginning
December 31, 2010. Complete the following amortization schedule.
Answer:
27. On January 1, 2009, Standard Incorporated is going to issue long-term debt in order to
obtain money required to finance the purchase of equipment. It will have to pay a market rate
of interest of 10% on this borrowed money. Standard is considering two different financial
instruments in order to obtain $10,494. The first instrument being considered is a 3-year,
12%, $10,000 note with interest payable every December 31 over the life of the note.
Alternatively, a 3-year, non-interest-bearing note with maturity value of $13,657 will be
issued. Show how Standard's January 1, 2009 balance sheet and 2009 income statement will
differ if Standard chooses to issue the non-interest-bearing note instead of the 10% note.
Answer: The present value of both financial instruments on January 1, 2009, at an 10%
market rate of interest is $10,494. Because each note payable would be carried on the balance
sheet at its present value, Standard’s January 1, 2009, balance sheet would be unaffected by
the choice of financial instruments issued. The presentation under each of the alternative
liabilities at January 1, 2009 would be:
Because interest expense is the market rate of interest times the carrying value at the
beginning of the year, during 2009 interest expense would also be the same. Under either
financial instrument, interest expense would be .10 x $10,494 = $1,049. Net income for 2009
would be unaffected by the choice of notes.
28. On January 1, 2010, Gee Company issued a 2-year, 8%, $20,000 installment note
payable. The payment on this note is $11,215 and is paid annually at year-end beginning
December 31, 2009. When the note was issued, the market rate of interest was 8%. Complete
the following amortization schedule.
Answer:
29. On January 1, 2009, Grant Company leased telephone equipment from Xu, Inc. Grant
uses straight-line depreciation. The contract requires Grant to pay $5,000 each December 31
for the next three years, at which time the equipment is to be returned to Xu. Using an interest
rate of 8%, the present value of the lease payments is $12,885. The following is Grant’s
January 1, 2009, balance sheet before the lease agreement.
Calculate and compare Grant’s debt/equity ratios on January 1, 2009, immediately after the
lease is signed, as an operating lease and a capital lease.
Answer: The liability and shareholders' equity section would be:
If the lease is considered a capital lease, the long-term solvency position of Grant as
measured by the debt/equity ratio has deteriorated. However, it should be noted that under
each condition, capital or operating lease, the future cash flows are the same. Therefore,
Grant’s "real" long-term solvency position is the same.
Use the table below to answer the problems 30 through 33.
30. What is the nature of the table presented? What is being amortized?
Solution:
This is a bond amortization table. Bond discount is being amortized over a three-year period.
31. Were the bonds issued at a discount or premium? How do you know?
Answer: The bonds were issued at a discount, evident by the fact that the issue price is less
than the face amount of the bonds.
32. Determine the coupon rate of interest on the bonds. What does this amount represent?
Answer: The coupon rate of interest determines the cash payment made to bond investors by
the bond issuer. The coupon rate is stated on the bond certificate. The coupon interest rate is
multiplied by the face amount of the bonds to determine the interest payment:
$40,000 (x) = $2,400
Solving for x, these bonds have an annual coupon interest rate of 6%.
33. Calculate the effective interest rate on these bonds. Why is this amount different than the
coupon rate?
Answer: $3,602 = (X) $36,021, so the effective rate is 10%. This amount is different than the
coupon rate because the market rate of interest changed during the time it took the bond
issuers to get the bonds ready to issue.
34. On January 1, 2009, Foresite Corporation issued a 10-year, 9%, $100,000 installment note
payable. The payment on this note is $15,582 and is paid annually at year-end beginning
December 31, 2009. How much total interest is paid over the loan period?
Answer: $15,582 x 10 = $155,820 – $100,000 = $55,820
35. On January 1, 2009, Justin Corp. leased equipment under a five-year lease with payments
of $20,000 on each December 31 of the lease period. The present value of the lease payments
is $77,800, using a market interest rate of 9%. Justin depreciates its equipment straight-line
over 5 years with zero salvage value. The capital lease criteria are met. Calculate depreciation
expense for 2009.
Answer: $77,800/5 years = $15,560
36. On January 1, 2009, Denver Company leased equipment under a 5-year lease with
payments of $5,000 on each December 31 of the lease term. The present value of the lease
payments at a discount rate of 12% is $18,024. If the lease is considered a capital lease, what
is the balance sheet value of the lease obligation on January 1, 2010?
Answer: $18,024 – [$5,000 – ($18,024 x 12%)] = $15,187
37. Crawford Company conducts a lottery system for Mississippi. The agreement specifies
that the lottery must be conducted on a not-for-profit basis. Crawford’s monthly sales of
lottery tickets amounts to $1,400,000. Monthly operating expenses are $400,000, including a
management charge of $30,000. The payment schedule for the guaranteed $1 million dollar
payout for a winning lottery ticket is $100,000 immediately and $100,000 each year for the
next 9 years. Crawford produced the following income statement as evidence of its not-forprofit status:
A. If the market rate of interest is 4%, determine the present value of the $900,000 liability
arising from the monthly winning lottery ticket.
B. Recalculate the income statement to reflect GAAP measurement of payout expense.
Answer: A. The present value of the liability is the present value of an annuity for 9 periods
at 4% multiplied by $100,000. This results in a long-term liability of $743,533.
B.
38. On January 1, 2010, Holly Company leased telephone equipment from ICON, Inc.
Straight-line depreciation is used on all equipment with no salvage value. The contract
required Holly to pay $5,000 each December 31 for the next three years, at which time the
equipment is to be returned to ICON. Using an effective rate of interest of 8%, the present
value of the lease payments is $12,885. Numerically derive the difference in Holly’s 2010
income if the lease is treated as an operating lease instead of a capital lease.
Answer: Under an operating lease, total expense in 2010 is the cash paid of $5,000. If the
lease is a capital lease, total 2010 expense is $5,326 (interest expense of $1,031* plus
depreciation of $4,295**). Therefore, 2010 income is more by $326 if the lease is treated as
an operating lease.
* Interest = $12,885 x 8% = $1,031 (rounded)
**Depreciation = $12,885 / 3 years = $4,295 per year
39. On January 1, 2010, Everton Company leased equipment under a 3-year lease with
payments of $10,000 on January 1, 2010, 2011, and 2012. The present value of the lease
payments at a discount rate of 9% is $27,591, which includes the immediate cash payment on
January 1, 2010. If the lease is considered an operating lease, how much is rent expense for
2010?
Answer: $10,000
Short Essay Questions
1. Branson Incorporated is considering leasing equipment. It can either lease the equipment
for five or ten years. The five-year lease allows Branson to classify the lease as an operating
lease. However, the ten-year lease requires Branson to classify the lease as a capital lease.
Branson is operating under a debt covenant that sets a maximum on its debt/equity ratio. If
Branson is close to violating this debt covenant, which lease contract would you advise
Branson to sign? Why?
Answer: If Branson is only concerned with the violation of its debt covenant that restricts its
debt/equity ratio, then it should lease the equipment for only five years under an operating
lease. Under an operating lease, the lease obligation is not recognized on the balance sheet
and will, therefore, not increase the debt/equity ratio. However, the cash payment obligations
under an operating lease are disclosed in the footnotes to the balance sheet. If Branson leased
the equipment for ten years that was recorded as a capital lease agreement, then it must
recognize the lease obligation equal to the present value of the minimum lease payments on
the balance sheet. This would increase Branson 's debt/equity ratio that might violate the debt
covenant.
2. Felton Incorporated is considering leasing equipment. It can either lease that equipment for
five or ten years with the same annual lease payments under either agreement. The five-year
lease allows Felton to classify the lease as an operating lease. However, the ten-year lease
requires Felton to classify the lease as a capital lease. If Felton desires to measure net income
higher in the initial year of the lease agreement, which lease contract would you advise Felton
to sign? Why?
Answer: If Felton enters into an operating lease, then rent expense equal to the lease payment
is recognized on the income statement. However, if the lease is a capital lease, then the
expense recognized on the income statement is equal to the depreciation expense associated
with the leased asset and interest expense resulting from the lease liability. During the early
periods of the lease contract, the depreciation and interest expense resulting from a capital
lease exceed lease payments (expense) associated with an operating lease (assuming equal
lease payments). The reason for this difference is that interest expense is recognized using the
interest method that recognizes greater interest expense during the early periods of the lease.
The difference is amplified if the lessee uses an accelerated depreciation method. Because the
initial year's expenses under an operating lease are less than that under the capital lease, the
net income under the operating lease is larger. Therefore, if Felton desires a higher net
income in the first year of the lease, it should sign the five-year operating lease. However, it
must be understood that total expense over the lease period will equal total cash paid for
leasing the equipment, independent of the type of lease.
3. Distinguish between an installment obligation and a non-interest-bearing obligation.
Answer: An installment obligation requires periodic payments that consist of both principal
and interest. Under the effective interest method, the dollar amount of principal increases and
the dollar amount of interest decreases as the maturity date becomes closer. A non-interestbearing obligation typically requires one payment that consists of both principal and interest.
Sometimes interest payments are made annually, and the entire principal is paid upon
maturity. Present value calculations are required in order to calculate both types of
obligations.
4. How do debt covenants impact a company's financial position?
Answer: Debt covenants are imposed by debt holders to protect their interest and to restrict
management by limiting long-term debt and lease obligations, by requiring that working
capital must be a certain percent or dollar amount, by limiting short-term borrowings, or by
restricting dividend payments. A company that violates restrictive covenants is said to be in
default, and the bondholders often have recourse when this happens.
5. What is the risk premium of a bond issue and what role does it play in the determination of
bond prices?
Answer: The risk premium is expressed as a percentage and reflects the probability that a
company will default on its periodic interest payments or the face value payment at maturity.
If this probability is high, the bonds would be considered “high risk” and the risk premium
would be relatively large (perhaps 5-10 percent). If the probability is low, the risk premium
would be considerably less (perhaps 1-3 percent).
The risk premium is associated specifically with the company issuing the bonds. It is
determined by a number of factors, including the credit rating of the company and the bond
issuance, the solvency and earning power of the company, future movements in the economy
and how these movements may affect the operations of the company, and the terms of the
bond issuance. Analyzing financial statements is an important part of assessing the risk
premium associated with investing in a particular company.
6. When the effective interest method is used to account for notes, the dollar amount of
interest will increase or decrease throughout the maturity period. Explain why.
Answer: The effective interest method assumes that larger amounts of interest relate to larger
debt balances. The carrying value of the debt is used as a basis on which to calculate interest.
If the carrying value the debt is larger, the dollar amount of the interest will be larger.
7. What are 'off-balance sheet risks'? What disclosures are required?
Answer: Off-balance sheet risks may consist of financial instruments not listed on the balance
sheet, many of which involve significant risk. Examples include commitments to guarantee
the credit of third parties, commitments to provide financing to customers who purchase
certain inventory items, and special financing arrangements that are designed to reduce the
risk associated with fluctuations in interest rates and the value of foreign currencies relative
to the U.S. dollar. Many of these are referred to as ‘derivative’ financial instruments.
Extensive disclosure is required to make users aware of situations that may cause a company
to experience a loss.
8. Various contractual forms specify additional terms such as collateral. Describe collateral as
it pertains to a company's debt.
Answer: Assets are often pledged as security, i.e., collateral, on a loan. If the required cash
payments, principal or interest are not met, the creditors (bond investors) can take the
collateral as payment for the debt.
9. Describe the two cash flows associated with bonds.
Answer: Bonds consist of two cash flows—interest payments, which occur periodically
throughout the bond term, and the bond principal. Most often bond principal matures at the
end of the bond term, but it might mature periodically in ‘chunks’ if the bonds are serial
bonds.
10. Why might a company redeem bonds before they mature?
Answer: Economic conditions (especially interest rates) change. Companies may wish to
retire debt with higher interest rates in order to secure debt with lower interest rates.
11. How does the balance between debt and equity in non-U.S. companies compare to the
balance of debt and equity in U.S. companies?
Answer: U.S. companies rely heavily on both debt and equity capital. This reliance influences
their accounting systems to provide information for both equity and debt investors. The
importance of earning power and solvency in the assessment of a company’s financial health
is emphasized in the U.S. Other countries such as Japan, Germany, and Switzerland are
characterized by having a few, very large banks that satisfy the capital needs of most
businesses. Stock and bond markets are not as heavily relied upon as they are in the U.S.
Japan has experienced above normal debt/equity ratios, often to be well in excess of 75
percent, most of it in the form of long-term notes financed by banks. International operations
such as these have disclosure requirements that are not as comprehensive as those in the U.S.
due to investor and creditor needs. In these countries, it is not unusual for a bank to have
members on a corporate Board of Directors for which they provide capital, in order to closely
monitor the company’s financial health. Japanese accounting rules set the ceiling on profits
available for dividends to shareholders. This ceiling insures there will be adequate cash
available to meet debt payments.
12. Describe the relationship between the stated rate of interest and the effective rate of
interest as it relates to bonds.
Answer: The stated rate is the rate of interest that is 'stated' specifically on the bond certificate
and in the bond indenture. The issuer is required to make interest payments based on the
stated rate. The effective interest rate is the rate the bond issuer will ultimately end up paying
when the cost of a premium or discount is weighted in. If a bond investor can earn, say 12%,
on a open market by acquiring investments of a similar risk, he will not be willing to accept a
lower interest rate which may be stated on a particular bond issue. In order to entice the
investor to purchase bonds at an interest rate that is lower than the effective market rate, a
discount must be offered. The discount coupled with the higher stated interest rate averages to
the interest rate the investor could earn in the market. The opposite effect occurs when the
two interest rates are reversed.
13. Why are some types of leases recorded as purchases?
Answer: Many leases which appear on the surface to be rentals, are actually purchases
financed with installment notes. The risk and benefits of ownership are essentially transferred
to the lessee. Accounting rules require that the lease be recorded based on its substance from
an accounting perspective. Legally, lease agreements do not transfer ownership, but in
substance, the contractual arrangement may appear to have transferred the rights, risks, and
benefits of ownership from the lessor to the lessee.
14. How does an investor's required rate of return affect investing decisions?
Answer: The decision to buy a bond requires the investor to compute the effective rate of
return and compare it to his or her required rate. The required rate of return is determined by
adding the return you could receive from investing your money in risk-free securities to the
risk premium that would be attached to the particular investment. The risk premium varies
from company to company. It is determined by a number of factors, including a company’s
credit rating and solvency, the earning power of the company, future movements in the
economy that may affect operations, and the terms of the bond issuance. Once an investor
compares his required rate of return with the effective rate he will earn on a particular
investment, he will make a decision. If the effective rate on the bond is less than in his
required rate of return, he will not purchase the bond.
15. How do changes in market interest rates lead to misstated balance sheet values for longterm debt?
Answer: If the market rate of interest remains constant over the life of a debt obligation, the
obligation’s balance sheet value will equal its present value. As market interest rates change,
the present value of the obligation discounted at the market rate of interest differs from the
balance sheet value of the obligation, which is discounted at the original effective interest
rate. This makes the balance sheet value of the debt inaccurate as a measure of the True
present value. Economic gains and losses are experienced, but not recognized on the financial
statements of the debtor.
16. What is the purpose of interest rate swaps?
Answer: Interest rate swaps are used to hedge market interest rate risk and to manage interest
rate risk.
Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt
9780470635292, 9781119537571, 9781119444367
